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Tuesday, July 27, 2004

Productivity: Higher than Overseas?

A question that has been troubling me for some time, is if American society is so darned fragging productive why is it that our companies are regularly outcompeted by foreign companies? An example is the car industry, which according to the NYT is about to get left behind, again.

ONE does not often hear financial analysts talk about climate change, but this month John A. Casesa, an analyst at Merrill Lynch, organized a teleconference to address a troubling question for Detroit's automakers: As regulators around the world move to curb global-warming emissions from cars and improve fuel efficiency, what happens if Wall Street adds up the costs?

The most likely answer will not make General Motors and Ford Motor very happy. Mr. Casesa's call included a presentation by the World Resources Institute, an environmental policy group in Washington, which recently issued a report on the subject with Sustainable Asset Management, an investment group based in Zurich.

The report forecasts that G.M. and Ford stand to lose the most, financially, of any automakers in complying with regulations that the groups expect the United States, Europe and Japan to adopt over the next decade - rules in addition to the pollution controls put in place over the last half-century.

Ford would have to spend $403 more on each vehicle to meet the expected new standards, the report estimates, and G.M. would have to spend $377 more. By contrast, the added cost to Honda would be just $24.

Car for car, BMW would have to spend even more than Ford or G.M., $649 on each vehicle, the report found, but because its prices are much higher, it would not be as difficult for it to absorb the cost.

Perhaps the most troubling finding for G.M. and Ford, the last two major automakers based in the United States, is that some foreign competitors, particularly Toyota, may actually be helped by tougher regulations because they have already invested much more in fuel-efficiency technologies, like hybrid gas-electric engine systems, that could generate profits.

Regulations related to fuel economy and global warming are "going to be one of the key drivers that determines competitiveness in the industry over the next decade and beyond,'' said Duncan Austin, who until recently was a senior economist at the World Resources Institute. He left to join a new investment firm that plans to use financial analysis to assess the effects of environmental rules and social trends.

One problem for analysts and investors who try to estimate these costs is predicting the outcome of the regulatory process, including the practical effects of voluntary agreements between governments and industry.

The whinging by industry about "extra-costs" of regulation is often short-sighted. Progress comes from change. American industry has been able to lobby itself into avoiding embracing new technologies, technologies which if embraced would have better prepared the American economy and the car industry in this for the market reality of higher oil and gas prices. However, the automobile industry has in this case lobbied itself into a dead end.

But looking beyond merely the car industry, there's a problem with the notion of America being "more productive" than Europe in general (courtesy of reader John St. Lawrence who sent this link to me).

Everyone knows the story by now. America may have its social problems, but its highly productive, job-generating, innovative economy is the envy of the world. Europeans, on the other hand, are in a despond of high unemployment and economic sclerosis. Europe's addiction to welfarism--its overcooked social contract--is killing the economic goose that lays the social egg. Americans may pay a price in inequality for their economic vitality, but when you take the country's extraordinary social mobility and opportunity into account the price is worth paying. You might want to reverse Bush's tax cuts for the very rich, but nobody sane is going to tinker with the essence of the great American Business Model that delivers so much wealth.

I contend--unfashionably and, I know, incredibly, given the consensus--almost the opposite. The American economy has great strengths, but it is not so all-conquering. And the American Business Model, with its ruthless focus on shareholder profits, has profound weaknesses. Indeed, American industry is at its strongest where it has not observed antistate, progreed precepts and operated in more European ways. Smart action by the state, a viable social contract and efforts by companies to harness human capital and serve a purpose larger than short-term profit maximization turn out to be indispensable components of successful American capitalism as well--though America's public conversation hardly concedes these points. It's a gaping omission that is costing the country dearly...

America's once proud culture of business building has given way to a culture of financial engineering, a doctrine of shareholder value maximization and a cult of the takeover. The game is to keep the share price up, and every sinew of the organization is bent to that end; shortcuts are ever tempting, and inevitably some companies resort to straight fraud. Nevertheless, the conservative inclination is to overlook one or two bad apples like Enron and WorldCom and to celebrate the rule of America's capital markets. It is Wall Street constantly holding corporate managements to account that drives up innovation and productivity, or so runs the conventional argument, with companies that fail to keep up facing a takeover.

Yet the evidence is that takeovers fail to raise shareholder value; consultant KPMG reports in a survey of 700 takeovers that more than four out of five either added no value or lost it. Still, investment banks continue to seduce overpaid CEO after CEO into believing that his deal will be the exception. And with share options that will provide fortunes if the deal comes off and golden parachute clauses that will secure an equally good pay-off if it bombs, most CEOs fall prey to the seduction. Despite a welcome wave of criticism of this febrile, amoral atmosphere, few took note in the heady days of the dot-com and telecom bubbles that this system was hollowing out the US economy. It is coming back to haunt the United States now...

This is the reality behind the ballooning current account deficit numbers. The US economy may boast an innovative IT sector and technological leadership in the military industry; beyond that, its claims for universal competitive strength are more and more dubious. Of course, America is home to some great companies, but not so many to justify the fawning acceptance that the American Business Model is better in every respect than the European one.

Europeans do not view the company as a casino chip to be traded away in a single-minded quest to enrich directors and shareholders. Rather, they see companies as living things, each one a network of human relationships organized to serve an overriding economic and social purpose. In the European perspective, a company has a defining organizational reason-to-be that serves as a jumping-off point for maximizing profits, a repudiation of the idea that anything goes in the quest for a fast buck. A company needs to be built over time, as resources are husbanded, personnel are groomed and trained, customers courted and innovation nurtured; its directors need to manage a complex set of trade-offs between the demands of shareholders and stakeholders, marketplace trends, the need to innovate and the engagement of employees. In this view, if only one voice counts--shareholders who want fast returns now--the company risks ruin.

The United States is vandalizing this conception of the company--once inherent in American capitalism--and is pulling down the structures that support innovation and productivity. It is Europeans who now invest more, sustaining a range of institutions that produce a highly skilled work force and a business-building culture. They may at first sight look like economic tortoises; in fact, they are set to overtake the American hare. High European unemployment, concentrated in Germany, which has made massive mistakes in macroeconomic policy by fixing its exchange rate too high within the euro, disguises the real performance of the European economy: Unemployment is lower in seven European Union countries than in the United States, and on the continent as a whole the participation rate of 25-to-54-year-old men in the labor market is almost the same as in the United States. As the euro becomes embedded, Europeans will secure the advantage of a single continental market even larger than the United States; when they get their macroeconomic policy right, the advantages of their economic and social model will become more evident.[emphasis added]

This is a provocative thesis. I don't know about that. What I do know is that Airbus is beating the pants off of Boeing. What I know is that foreign car makers have been more successful than American car makers. What I know is that in many areas, from steel, to agriculture, to telecom, to financial services, that the momentum seems to be on the side of the Europeans and not American companies. This is not true in every case, and it is true that American dominance in many fields still prevails but more and more this seems to be an artifact from the past.

Recently it wasn't just manufacturing old-economy companies that had a trade deficit, but America started bleeding red on the hi-tech trade items too in our current accounts balance. Frankly the only sector in which we seem more competitive than our overseas competitors on an industry-wide basis is simply financial services, and that is quickly eroding as well.

So if many of our companies aren't competing well in the global market place, how can we be more productive than other societies? We might be, but at the very least the discrepency calls into question either what we mean by productivity or what the benefit of focusing on such a metric is.

The gap is even widening. This year the U.S. should record productivity gains of 3.3%, according to Eurostat, the statistical agency of the European Union. That's almost twice the rate of France and Germany and well above the British rate (yes, even dynamic Britain is struggling in this area). Europe now has an hourly output per worker some 20% below American levels...

Start with the issue of info-tech spending. A key to productivity increases is using IT to get the most out of workers and plants -- whether it's customer-relationship software in a sales office, process-control technology in a factory, or inventory-tracking systems in a store. European companies have ample access to all this knowhow from U.S. and Asian tech providers, not to mention from other European firms such as software giant SAP (SAP ), industrial powerhouse Siemens (SI ), or mobile-phone maker Nokia .

A DIFFERENT MIND-SET But this is where the differences between Europe and the U.S. become stark. European executives have invested much less in IT than have their U.S. counterparts. According to the Organization for Economic Cooperation & Development, in France, spending on information and telecommunications technology accounted for 1.97% of gross domestic product in 2002. U.S. IT spending accounted for 4.42%. That partly reflects differences in mind-set, says Roger Fulton, an analyst in the British office of IT researcher Gartner Inc. (IT ) "The U.S. is a 'just do it' society, whereas Europe has more of a 'let's think about it' society." That results in a greater hesitancy to buy into the benefits of IT and, therefore, to lower IT spending.

There's also a chicken-and-egg problem with IT investment in Europe. Heavy spending can help a company produce more with fewer workers -- often making layoffs inevitable, even desirable. "But the labor market is less flexible in Europe than in the U.S.," says Kasper Rorsted, managing director for Hewlett-Packard Co. (HPQ ) in Europe, the Middle East, and Africa. "Employees in Europe are seen as more of a fixed cost -- not something you can easily trim." With the cost of laying off a worker so high in Europe, companies hesitate to spend on labor-saving information technology in the first place. Rorsted is so concerned about low IT spending in Europe that he confers monthly with policymakers in Brussels on crafting investment incentives and loosening regulation...

Europe also simply doesn't have as large a tech sector as the U.S. That matters because fast-growing technology companies are themselves major contributors to productivity growth. According to McKinsey & Co., the IT sector generates 2.3% of total GDP in the U.S., but only 1.3% and 1.5% in France and Germany, respectively. McKinsey says that the U.S. tech sector accounts for more than a quarter of the entire economy's productivity growth. (Some studies suggest it is much higher.) In contrast, a smaller IT sector generates less than 20% of productivity growth in Europe.

At the same time, says Dirk Pilat, senior economist at the OECD in Paris, fewer new businesses -- most of which generate strong productivity growth if they survive -- are created in Europe. "You just don't get the same productivity impulse from new companies here," he says.

Europe also spends less on research and development -- about 2% of GDP, vs. nearly 3% in the U.S. Spending on R&D usually boosts productivity, too, as new processes and easier-to-make products flow from the labs to the assembly line. And many of the big European R&D spenders, such as Novartis (NVS ), are shifting more of their R&D to the U.S. to be closer to their biggest market. German-based BASF (BF ), for example -- the world's largest chemical company -- is not only trimming R&D spending but also deciding whether to move its genetically modified crop research across the Atlantic. Such moves mean that the U.S. economy benefits more than Europe does from any productivity payoff that comes from R&D.

Even if IT and R&D expanded dramatically in Europe, it's not clear whether they would have the intended effect...

Take Germany. The legal separation of commercial, savings, and cooperative banks in Germany means that there has been little financial sector consolidation. German banks have invested heavily in information and communication technology and developed highly efficient payment, customer-relations, and online-banking systems. But without the chance to exploit the economies of scale that come with consolidation, they can't derive maximum productivity benefits from it. The average German bank's productivity is 13% lower than its U.S. counterparts as a result.

There are even productivity-busting restrictions in Britain, the fastest-growing big economy in Europe. British retailer Tesco PLC (TSCDY ) over the past 10 years has spent heavily on IT. Retailing analysts estimate that Tesco's labor productivity growth has been about 1% a year higher than the recent British average for the past five years. "Their distribution systems are as tight as they can be," says Nick Isles, associate director at the Work Foundation, an independent research consultancy in London. That benefits Tesco's efficiency because it delivers the right goods at the right time.

Yet for all its success, Tesco hasn't been able to chalk up as many productivity gains as it could. One reason, say industry experts: Tough British planning laws make it harder to open large new supermarkets than in the U.S. That means Tesco can't fully benefit from productivity gains by setting up new shops and achieving the economies of scale it would in a less regulated environment.

Could Europe have a productivity spurt? Yes. Take what happened in the German electricity and gas market when it was liberalized in 1998. Wholesale prices fell, forcing power generators to improve their traditionally low productivity levels by investing heavily in IT -- $5.6 billion in 2000 alone. Annual productivity in the sector has risen 3.5% since. By contrast, Electricité de France, a state-owned virtual monopoly, has invested just a fifth as much in IT in recent years as has the German power sector. One result, say consultants: Labor productivity growth at EdF is less than a sixth of German levels.[emphasis added]

Proponents of the productivity boom have long argued that technology improves productivity. Apparently it doesn't, because the case of Europe shows that merely investing in the technology doesn't increase the productivity. What improves the productivity compared to Europe is the ability to use technology to replace workers. Well that's a fair if not-well-voiced argument. Automation does and can be used to promote progress by eliminating the use of labor in some areas.

Other areas of "productivity" growth cited in the article are much less valid however. For instance, the increased productivity of American financial sector seems to be based upon their ability to merge and consolidate, and therefore lay off workers. The previous article cited a KPMG study that indicated that most mergers do not add shareholder value, so the productivity gains are not through "synergy" but "cost-cutting" which means really cutting workers. Likewise the cited ability of the American retail sector to have greater productivity isn't by increasing technology or distribution patterns, it's from laws that allow them to move into areas and undercut local stores something that British laws discourage. Without Walmart being able to put mom and pop stores out of business, there would be no apparent productivity gap there then. And the fact that the big tech companies themselves add to our productivity, is itself a completely inappropriate contribution - especially if anyone remembers the hype and the illusion of the internet boom. The fact that the growth of tech companies themselves on their speculative capital investment basis are the basis of a quarter of US productivity growth is high disturbing.

It is a valid observation though that the Europeans invest less in hi-tech and especially R&D. It is also true that fewer new businesses are created in Europe, and so they don't have that entrepenuerial productivity bang. So I would think that even on a level playing field that America's productivity rating might have those things in its favor.

However investing less in hi-tech may be a rational decision in an environment where one cannot use it to displace workers easily. In other words, those particular productivity gains obtained by the gap in IT spending is really not a gain from IT as much as a gain from displaced workers. In the original paradigm of mechanized automation, displaced workers would eventually get better jobs in new industries. However when we combine this process with the globalized offshoring trend toward capital flight overseas to cheap labor, then we don't see new high quality or value-added jobs being created to replace the old ones displaced by mechanization.

When we combine this with the observations of the previous article, it seems clear that American companies and its economy is not more productive because they are sharper, better at competing, or have better technology but because their regulatory environment favors them and they are allowed to offshore their work to lower cost structures using foreign workers. Outside of this environment, when you actually let American companies compete on a level playing field they have much more difficulty - sometimes especially because they were coddled by our regulatory structure.

This is the strange combination that has developed, and helps explain the increased corruption in American business management. When success becomes about access and favorable regulatory lobbying, then the company and its executives become focused on political influence and dealing rather than improving their business model or products. Outside of this "hothouse" atmosphere, American companies are trending toward becoming less independent of the government and less able to compete on a level playing field in a free market. It is strange that America, the land that praises the free market, should become ever increasingly the model of a regulatory protectionist state.